In today’s Mises.org article I elaborate on the Keith Hennessey chart showing projected fiscal trends through 2060. I walk through a numerical example showing the connection between government deficits and debt, as a % of GDP. (It’s a bit counterintuitive–you can set any level of perpetual deficits that you want, and there is an associated debt-to-GDP ratio that would be stable at that constant deficit.)

Here’s an excerpt of the Austrian product differentiation:

Contrary to Keynesians, the problem with government budget deficits is not merely that they (typically) lead to higher interest rates and thus reduce private-sector investment and consumption spending. Because, in this context, the Keynesians only look at economic factors insofar as they work through “aggregate demand,” they understandably think that large deficits can’t possibly hurt anything when interest rates are practically zero.

However, Austrian economists have a much richer model of the capital structure of the economy. In this view, economic health isn’t simply a matter of propping up total spending high enough to keep everybody employed. On the contrary, resources need to be deployed in particular combinations in particular sectors of the economy, so that semifinished goods can be transformed step-by-step as they move through the hands of various workers at different businesses and finally onto retail shelves.

Dr. Murphy,
Hello. I haven’t had a chance to look at your article yet so if I am asking about something that it already covered, please disregard my question and accept my apologies.
Whenever I see charts of the deficit and projected deficit I get really worried. However, I have read in different places that the deficit as a percentage of GDP was a lot higher during World War 2 than it is now. So, if the WW2 debt/deficit didn’t lead to such dire circumstances, why should we be so worried now?

Well, the US actually cut spending drastically when the war ended, and the US was still demographically healthy, even with the baby bust of the Depression years. Right now, those kinds of drastic spending cuts don’t seem to be on the table.

I need to run a deficit, it’s the only way to inject financial resources into the economy. If I’m not running a deficit, then I’m draining the pockets of the private sector. I was at a meeting in Cambridge last month where the managing director of the IMF said he was against my deficits but in favor of saving, but they’re exactly the same thing! My deficit means more money in private pockets.

re: “However, Austrian economists have a much richer model of the capital structure of the economy. In this view, economic health isn’t simply a matter of propping up total spending high enough to keep everybody employed. On the contrary, resources need to be deployed in particular combinations in particular sectors of the economy, so that semifinished goods can be transformed step-by-step as they move through the hands of various workers at different businesses and finally onto retail shelves.”

From my perspective, this is an odd way of looking at it. Keynesians aren’t resistant to disaggregation. Heterorgeneity in capital is incorporated into published Keynesian models all the time, and while disaggregation can keep going and going until you get to the individual agent, you’ll see more of it in, say, Lawrence Klein than you will in Roger Garrison. That doesn’t seem to be the major dispute at all. The concern is the question of what Keynes himself called only a “first approximation” – the question of sufficient effective demand. It’s hard to spend time talking about capital structure on a more detailed level when people won’t accept the basic propositions associated with effective demand, you know? When some people claim it’s all a matter of the readjustment of intertemporal discoordination, I think Keynesians are simply of the opinion that there are bigger fish to fry (namely pushing the effective demand point). No Keynesian that I know would protest a richer model of the capital structure (do you know of any?). It just doesn’t strike us as the first priority to talk about, particularly since the price mechanism provides for relative coordinations… in a sense there simply isn’t as much to talk about. Keynesians focus on what the price mechanism cannot solve (macro-underutilization), rather than on the issues that all Keynesians I know of admit the price mechanism can solve (micro-coordination and relative utilization of resources).

It’s like Keynes said in the conclusion to the General Theory:

“To put the point concretely, I see no reason to suppose that the existing system seriously misemploys the factors of production which are in use. There are, of course, errors of foresight; but these would not be avoided by centralising decisions. When 9,000,000 men are employed out of 10,000,000 willing and able to work, there is no evidence that the labour of these 9,000,000 men is misdirected. The complaint against the present system is not that these 9,000,000 men ought to be employed on different tasks, but that tasks should be available for the remaining 1,000,000 men. It is in determining the volume, not the direction, of actual employment that the existing system has broken down.”

No Keynesian that I know would protest a richer model of the capital structure (do you know of any?).

It depends on what you mean by “a richer model of the capital structure”. Hayek’s model was rejected by various economists, including soon to be converted Keynesians, such as Sraffa, Samuelson, Kaldor, Keynes, et cetera.

Also, your quote of The General Theory seems a bit misplaced. Keynes is talking about a period of recession. Intertemporal disallocation is the cause of the recession. Once factors of production are idle it follows that they are no longer employed, so it would be absurd to argue that they are simultaneously misemployed.

That’s right – there are differences on what “a richer capital structure” means and nobody is going to entirely agree on any given formulation (even within the Austrian camp). My point is more that the Keynesian position is not “I will defend my homogenous blog of K to the death, damn it!”. Instead it is “first things first – let’s set capital aside for the moment and focus on this massive mistake of conflating the interest rate with the marginal efficiency of capital”.

If you think Keynesians say the first thing – which SHOULD be absurd for anyone to think – then one might criticize them for it. If you think they say the second thing, then there’s really no grounds for criticism – particularly in light of the fact that a lot of Keynesians have pushed the heterogeneity of capital a lot farther than most Austrians.

You know I think a time-structure of production a la Hayek ought to be incorporated into a Keynesian model with the liquidity preference theory of interest – at least to pin down all the implications. But these “richer” capital structures don’t provide any reason to drop the fundamental Keynesian concerns with the liquidity preference theory of interest, do they? Not in any way that I’m aware of.

But these “richer” capital structures don’t provide any reason to drop the fundamental Keynesian concerns with the liquidity preference theory of interest, do they? Not in any way that I’m aware of.

It is not necessary that “richer” capital structures has to lead to a dropping the liquidity preference theory of interest before it becomes reason enough to use it. The liquidity preference theory can be dropped by simply understanding what generates interest in the first place.

It is not a question of saving and investment each being acted upon by the interest rate. Saving, investment, and the interest rate are each determined at the same time by individual subjective time preferences on the market. Liquidity preference has nothing to do with this matter.

The liquidity preference theory claims that if the “speculative” demand for money rises in the depths of a depression, then this will increase the rate of interest. However, this is not necessary. Increased cash “hoarding” can come from funds formerly consumed, from funds formerly invested, or from a combination of both that leaves the old consumption-investment proportion unchanged.

Unless individual’s time preferences change, the third alternative above will be the one that results. Hence, the rate of interest depends solely on time preference, and not on “liquidity preference.”

If the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall, but that is because time preferences has fallen.

One should drop the liquidity preference of interest because it’s wrong as such. Understanding heterogeneous capital is not needed to drop it.

re: “The liquidity preference theory can be dropped by simply understanding what generates interest in the first place.”

Liquidity preference theory PROVIDES the understanding of what generates interest in the first place. The Austrians provide an entirely different story of how the capital structure reacts to changes in the interest rate. I think that’s great. I enjoyed Hayek and Garrison. Their problem is not in their capital theory – it’s that they cling to a purely loanable funds theory of the interest rate.

Liquidity preference theory PROVIDES the understanding of what generates interest in the first place.

No, it provides an incorrect understanding on what generates interest in the first place.

Interest rates simply are not generated by liquidity preference. They are generated by time preference.

A higher or lower liquidity preference will not change the rate of interest, if people change their consumption and investment in the same proportion as existed before, leaving the difference unchanged. This is because while changing liquidity may lead to fewer or greater nominal finds available for loans, it is also true that the prices of factors of production as well as outputs will be equivalently decreased or increased as well.

On a related note, even the Keynesian economist Modigliani concedes that the only way liquidity preference can block full employment is if liquidity preference were infinite, which is an impossibility anyway since people need to consume, and if they need to consume, they will save and invest. And even if people did hoard more and more cash, it will speed up the readjustment process of the problems that made the hoarding necessary in the first place.

I think that’s great. I enjoyed Hayek and Garrison. Their problem is not in their capital theory – it’s that they cling to a purely loanable funds theory of the interest rate.

Well, both use loanable funds theory as a proxy for time preference, since abstaining from consumption and making more funds available for investment is just another way of saying that time preferences have decreased. That is why interest rates decrease.

From my perspective, this is an odd way of looking at it. Keynesians aren’t resistant to disaggregation. Heterorgeneity in capital is incorporated into published Keynesian models all the time, and while disaggregation can keep going and going until you get to the individual agent, you’ll see more of it in, say, Lawrence Klein than you will in Roger Garrison.

Murphy said that Austrians have a “much richer model of capital structure.” He didn’t actually say that Austrians have “a” model of capital structure.

The fundamental factor that separates Austrians from Keynesians on capital theory is the fact that Austrians include time in the structure of production. This is probably what Murphy was alluding to when he said that Austrians have a “richer capital theory”.

But to be fully accurate, Keynes the man did not disaggregate capital at all. He treated capital as a single homogeneous blob, which he referred to as “K”. Combine that with his emphasis on the “marginal efficiency of capital”, and you can see why Austrians would hold Keynesian economics to be lacking in adequate capital theory.

Having said that, you’re absolutely right that economists who call themselves Keynesians have published models that treat capital as heterogeneous, but to the extent that they do this, they are actually moving away from Keynesianism proper. In fact, it could be argued that many Keynesians have adopted more heterogeneous treatments of capital precisely because they recognized and understood the Austrian argument that doing so is crucial, if one is going to have a correct understanding of the economy that is.

That doesn’t seem to be the major dispute at all. The concern is the question of what Keynes himself called only a “first approximation” – the question of sufficient effective demand.

Which is really just another way of saying don’t pay attention to capital structure.

It’s hard to spend time talking about capital structure on a more detailed level when people won’t accept the basic propositions associated with effective demand, you know?

That’s probably true, but there is no reason to accept propositions when there are weaknesses associated with them.

When some people claim it’s all a matter of the readjustment of intertemporal discoordination, I think Keynesians are simply of the opinion that there are bigger fish to fry (namely pushing the effective demand point).

Pretty much, but the Austrian position is that there are much bigger fish to fry than aggregate demand, namely, the intertemporal discoordination, which they hold to be the *reason* why aggregate demand falls.

No Keynesian that I know would protest a richer model of the capital structure (do you know of any?).

Um…is that a serious question?

It just doesn’t strike us as the first priority to talk about, particularly since the price mechanism provides for relative coordinations… in a sense there simply isn’t as much to talk about.

The price mechanism cannot work if it is being manipulated by central banks and the Treasury.

Keynesians focus on what the price mechanism cannot solve (macro-underutilization), rather than on the issues that all Keynesians I know of admit the price mechanism can solve (micro-coordination and relative utilization of resources).

The Austrian position is that the problem of under-utilization of resources is a symptom, not a cause, of depressions. They signal malinvestment of scarce resources, not an arbitrary stinginess of scared investors.

Captain Freedom –
re: “The fundamental factor that separates Austrians from Keynesians on capital theory is the fact that Austrians include time in the structure of production.”

I was operating under the assumption that this is what Murphy was alluding to, but it’s simply not true. For starters see ch. 11 and 16 of the GT, don’t accept everything you read on mises.org, and remember that because this element of Austrian theory is not a feature of the causal mechanism in the Keynesian theory does not mean that it is somehow a difference of opinion.

re: “But to be fully accurate, Keynes the man did not disaggregate capital at all. He treated capital as a single homogeneous blob, which he referred to as “K”. Combine that with his emphasis on the “marginal efficiency of capital”, and you can see why Austrians would hold Keynesian economics to be lacking in adequate capital theory.”

Again, this does not square with my understanding of Keynes. What I think you mean is that the first approximation of the theoretical mechanism doesn’t rely on the heterogeneity of capital in the way that the Austrian theoretical mechanism does. That’s a very different claim, I think.

re: ” but to the extent that they do this, they are actually moving away from Keynesianism proper.”

Again, you are assuming there is some conflict between Keynes and disaggregation. When he wrote up something that he called a first approximation, and when he at several points noted the heterogeneity of capital, why are you thinking that moving on to a second approximation is “moving away from Keynesianism proper”??? I’m curious why you make the assumption about their motivation for doing this that you do.

re: “That’s probably true, but there is no reason to accept propositions when there are weaknesses associated with them.”

There are lots of reasons to underemphasize something if they are entirely incidental to your theory!!! When you let me know what capital heterogeneity changes about the implications of a liquidity preference theory of the interest rate, I’ll admit that Keynes was wrong to not spend much time on capital heterogeneity.

re: “Pretty much, but the Austrian position is that there are much bigger fish to fry than aggregate demand, namely, the intertemporal discoordination, which they hold to be the *reason* why aggregate demand falls.”

I was operating under the assumption that this is what Murphy was alluding to, but it’s simply not true. For starters see ch. 11 and 16 of the GT, don’t accept everything you read on mises.org, and remember that because this element of Austrian theory is not a feature of the causal mechanism in the Keynesian theory does not mean that it is somehow a difference of opinion.

Patronization regarding mises.org aside, you’re actually wrong to suggest that Keynes integrated time into his capital structure treatment in the GT. In chapters 11 and 16, Keynes only mentions time in passing, to make subsidiary comments on topics other than capital structure, for example labor and interest. Never does he integrate time into capital structure. He treats capital as a homogeneous fund that he says, in passing, can vary in terms of time to completion, but that time refers to simplistic capital “K” -> Consumption. It does not refer to the time *within* the capital structure from stage to stage, and then to final completion and sale of consumer goods.

His circular flow of income, which is assumed to be taking place all at once, should have made it obvious that Keynes does not integrate time into his treatment of capital.

Again, this does not square with my understanding of Keynes. What I think you mean is that the first approximation of the theoretical mechanism doesn’t rely on the heterogeneity of capital in the way that the Austrian theoretical mechanism does. That’s a very different claim, I think.

No, I meant what I actually said. The “first order approximation” of Keynes doesn’t rely on the heterogeneity of capital at all. It’s not that Keynes didn’t rely on it the way Austrians rely on it. In the GT, it’s completely absent.

For some reason that is lost on me, you seem to want to characterize Keynes’ treatment of capital as being time based and heterogenous, just not in the same way as the Austrians. There is nothing that Keynes wrote that would suggest such a thing.

Again, you are assuming there is some conflict between Keynes and disaggregation.

When he wrote up something that he called a first approximation, and when he at several points noted the heterogeneity of capital, why are you thinking that moving on to a second approximation is “moving away from Keynesianism proper”???

There is nothing in the GT that would suggest that Keynes integrated heterogeneous capital into his actual treatment of capital.

Merely claiming otherwise is not a valid argument.

I think you are conflating Keynesian economists who integrate time and heterogeneity into their models with Keynes the man, who did no such thing.

There are lots of reasons to underemphasize something if they are entirely incidental to your theory!!!

Aggregate demand is central to Keynesian economics. It is not in any way “incidental” to it.

When you let me know what capital heterogeneity changes about the implications of a liquidity preference theory of the interest rate, I’ll admit that Keynes was wrong to not spend much time on capital heterogeneity.

That is not what would make Keynes wrong to ignore time and heterogeneity in capital structure. What does show him to be wrong is exposing his belief in an attributing to aggregate demand, to “spending” as such, a causal force for economic progress, or the government’s inflation to allegedly halt economic retrogression while completely ignoring capital structure distortions that made aggregate demand fall in the first place.

Keynes’ treatment of capital leads to economists and policy makers to reverse the effects of capital structure distortions. These effects however are the symptoms, not causes, of depressions, and trying to reverse the effects does not fix problems with the cause, and in fact the cause is made worse. This is why stimulus spending prolongs economic agony. It is much like a doctor treating a sick patient by changing the grades on a patient’s thermometer, to make it seem like the patient’s temperature is lower, then scratches his head and wonders why the patient is not getting better and is getting worse.

Right – as I said, this is the difference.

Yes, and as I said, the difference is due to the fact that Austrians actually integrate heterogeneity of capital, whereas Keynes does not.

Captain Freedom –
I said he considers it but it’s not part of the causal mechanism that Keynes is primarily concerned with, nor does it change the causal mechanism that Keynes is primarily concerned with. I did not say that he offers a more detailed capital theory – I’m saying he notes that capital is more detailed, but that is not what the theory even addresses.

re: “No, I meant what I actually said. The “first order approximation” of Keynes doesn’t rely on the heterogeneity of capital at all”

What is the difference between “doesn’t rely on” and “doesn’t rely on at all”???

I’m not saying that! I’m noting he’s aware that capital is heterogeneous and has a time structure but for the purposes of his theory he’s not addressing that element of capital theory because it really has no bearing on what he’s saying about liquidity preference. Austrians act as if he is ignorant of it, or as if his points about liquidity preference would change if he had a richer theory of capital – neither of these points is true.

re: “Yes, and as I said, the difference is due to the fact that Austrians actually integrate heterogeneity of capital, whereas Keynes does not.”

Or alternatively, Keynes integrates liquidity preference and Austrians do not. The point is, these two approaches have entirely different foci. You are acting like they contradict each other in some way. I’m saying they are simply different. And Keynes at least acknowledged the heterogeneity of capital and acknowledged that his is a first approximation. He leaves room for elaboration in that sense. Austrians don’t even acknowledge the fact that they have an incomplete theory of the interest rate.

I said he considers it but it’s not part of the causal mechanism that Keynes is primarily concerned with, nor does it change the causal mechanism that Keynes is primarily concerned with.

It’s not that he is not primarily concerned with it in the causal mechanism. It’s that he is not concerned with it at all. That’s the point I am making that you seem to believe is refuted by pointing out that Keynes casually glossed over the heterogeneity of capital.

By your logic, if anyone claimed that Mises’s economics was based on dynamic entrepreneurial activity, of continuous economic changes, then I should say “NO NO! He casually glossed over the concept of the evenly rotating economy. Ergo, he did mention static conceptions of the market, which means Keynesian criticisms that he did not consider equilibrium analysis are simply wrong.”

I did not say that he offers a more detailed capital theory – I’m saying he notes that capital is more detailed, but that is not what the theory even addresses.

Daniel, instead of making claims to what Keynes did not say, and making claims on what you think others said about you, which leads you to constantly play this game of “I didn’t say that…”, as if anyone even accused you of it, try to actually read what people are saying. Where did I say that you said Keynes offered a more detailed capital theory, such that you need to go out of your way to tell me that you didn’t say that?

Now you are admitting that Keynes’ theory does not address heterogeneous capital and time structure of production. *That’s the only point Austrians are making*. They are not claiming that Keynes actually thought that capital was a single lump of shmoo that has no time structure and no heterogeneity. They are saying he did not integrate time or heterogeneity into his published theory, the theory that we are challenging, not Keynes the man.

What is the difference between “doesn’t rely on” and “doesn’t rely on at all”???

Good lord. Daniel, you wrote:

“What I think you mean is that the first approximation of the theoretical mechanism doesn’t rely on the heterogeneity of capital in the way that the Austrian theoretical mechanism does.”

I responded to that comment by saying it’s not just that his first order approximation doesn’t rely on heterogeneity of capital “in the way that the Austrian” theory relies on it. It is that his theory doesn’t rely on it at all. By saying that you think I meant that Keynes doesn’t rely on capital the way Austrians do, it clearly implies that Keynes does rely on it to some degree in his theory, when in reality, he does not. Merely mentioning it in passing is not the same thing as integrating it.

“Again, you are assuming there is some conflict between Keynes and disaggregation. When he wrote up something that he called a first approximation, and when he at several points noted the heterogeneity of capital, why are you thinking that moving on to a second approximation is “moving away from Keynesianism proper”???”

This statement clearly states that you claim Keynes integrated heterogeneity into his theory.

I’m noting he’s aware that capital is heterogeneous and has a time structure but for the purposes of his theory he’s not addressing that element of capital theory because it really has no bearing on what he’s saying about liquidity preference. Austrians act as if he is ignorant of it, or as if his points about liquidity preference would change if he had a richer theory of capital – neither of these points is true.

Ah, so your actual argument is nothing but a setting up of a straw man, which is “Austrians act as if,” and then you proceed to knock that straw man down.

Since nothing I have said would even remotely come close to me claiming that Keynes did not even recognize time or heterogeneity, then I am quite frankly puzzled as to why you are even bringing it up.

Or alternatively, Keynes integrates liquidity preference and Austrians do not.

That is not a valid equivalent alternative, because whereas Keynes accepts the Austrian argument that capital is heterogeneous and time based, but he does not integrate it into his theory, Austrians on the other hand hold liquidity preference theory of interest to be nothing but a figment of one’s imagination. They do not even recognize it, let alone integrate it.

Keynes integrated a fallacious doctrine into his theory. Time and heterogeneity are not fallacious concepts.

The point is, these two approaches have entirely different foci. You are acting like they contradict each other in some way.

There you go again…”you are acting as if”. STOP IT WITH THE STRAW MAN.

As I already argued above, the liquidity preference theory of interest is contradicted by what actually generates interest, which is time preference. It is not contradicted by the Austrian emphasis on time and heterogeneity, contrary to your claim that Austrians somehow think is the case.

I’m saying they are simply different. And Keynes at least acknowledged the heterogeneity of capital and acknowledged that his is a first approximation.

Huh? How can he at least acknowledging real world concepts of time and heterogeneity somehow move the ball in the Austrian’s court to “at least” accept the liquidity preference theory of interest? It goes against one of the core foundations of Austrian economics, which is time preference. You cannot fault the Austrians for not adopting a theory that Austrians hold to be not even a real world concept, let alone a concept that deserves integration in one’s model.

He leaves room for elaboration in that sense.

No, not merely elaboration, for he does not include time or heterogeneity in his theory at all. One cannot elaborate on what has not first been introduced in theory. He leaves room for someone else to add what he ignored in this theory.

Austrians don’t even acknowledge the fact that they have an incomplete theory of the interest rate.

How can Austrians have an incomplete theory of the interest rate on account of not including the liquidity preference theory, when the liquidity preference theory is fallacious? You’re making no sense.

re: “Where did I say that you said Keynes offered a more detailed capital theory, such that you need to go out of your way to tell me that you didn’t say that?”

You had said: “you seem to want to characterize Keynes’ treatment of capital as being time based and heterogenous, just not in the same way as the Austrians”

I’m saying I’ve never even attempted to suggest that Keynes offered this more detailed version of capital theory that the Austrians offer. Don’t accuse me of claiming and then get mad when I assure you I’m not claiming it.

Let’s put aside the he-said-she-said on Keynes. That’s a historical/textual/misunderstanding of comments question, so forget that for now

Notice how you and I are vehemently disagreeing on liquidity preference but not disagreeing at all on capital heterogeneity. That’s my only point. It’s the interest rate that Keynesians and Austrians disagree on, not capital theory. Whenever you guys complain about homogenous capital do you notice that Keynesians never seem to leap in to defend homogenous capital? Have you ever considered that the reason for that is that they don’t disagree with you on it?

I’m saying I’ve never even attempted to suggest that Keynes offered this more detailed version of capital theory that the Austrians offer.

[Facepalm]. Daniel, sorry to say, but you’re a debate snake. You keep arguing against positions I did not espouse.

I did not say that you attempted to suggest that Keynes offered THAT more detailed version of capital theory, meaning as detailed as the Austrians. I said that you seem to imply that Keynes integrated it at all in his theory. You seem to imply this after you argued against a straw man that Austrians allegedly claimed that Keynes never considered time or heterogeneity at all in anything he said in any way. By arguing against that straw man, you are implying to me and others that you think Keynes did take them into account in his theory. Whether or not you actually believe that is a different story. But what you said does give that impression, whether you intended it or not.

Don’t accuse me of claiming and then get mad when I assure you I’m not claiming it.

Are you serious? After you just accused me and other random Austrians of claiming things that I did not?

NO IT HASN’T, as is clear from your statements to the contrary, specifically, that Keynes did not ignore time or heterogeneous capital, as if the mere passing mention of them means Austrians cannot criticize him for failing to take them into account!

You’re incredibly frustrating. You keep making straw man claims and then you have the gall to accuse others of straw manning you!

It goes against time preference by denying/ignoring the fact that interest is generated by time preference, not liquidity preference. The liquidity preference theory cannot explain interest without implicit or explicit reference to time preference, which actually generates interest.

All of mainstream economics accepts time preference and a lot accept liquidity preference.

A lot of mainstream economics is contradictory. It doesn’t matter how many people accept this or that when it comes to what is true or false. What matters is the arguments themselves.

It goes against an exclusive reliance on time preference, but there’s nothing preventing the coexistence of liquidity preference and time preference concerns.

Sure there is. I have already argued, which you have not responded to by the way, that a higher or lower liquidity preference will not change the rate of interest unless the increased or decreased liquidity preference occurs alongside a change in time preference.

If time preference does not change, then any increase or decrease in liquidity preference will not operate to increase or decrease the interest rate.

re: “I said that you seem to imply that Keynes integrated it at all in his theory.”

And no matter how many times I tell you that I never implied this for whatever reason you’re choosing to infer this, you’re still pushing this. Why?

I’ve said, from the start:

– Keynes talked a lot about heterogeneous capital in the initiation of his discussions of capital.
– As he formulated his “first approximations” he introduced simplifying assumptions, including homogenizing capital
– Adding capital heterogeneity doesn’t change the Keynesian mechanism and the behavior of capital from the first approximation model.

I’ve said this over and over and over again. Forget what you think I’m implying – this is all I’ve ever said. I’ve never suggested anything else.

I don’t know why you are so hell-bent on not taking my own word for what I am saying so that you can formulate my argument that makes us disagree more than we already do.

All I’m suggesting is this – Let’s put aside the he-said-she-said on Keynes.

You mean you are going to completely switch gears and make a separate argument? The whole basis of your argument is what Keynes said and did not say.

But whatever, if you want to try something else, by all means…

That’s a historical/textual/misunderstanding of comments question, so forget that for now
Notice how you and I are vehemently disagreeing on liquidity preference but not disagreeing at all on capital heterogeneity.

Uh, no, it’s capital theory, among many other areas. Keynes’ theory holds time and heterogeneity of capital to be unimportant and not causal. He holds aggregate demand, specifically consumption, to be the fundamental driver of economic progress.

Whenever you guys complain about homogenous capital do you notice that Keynesians never seem to leap in to defend homogenous capital?

My guess is that is because they don’t even understand the implications of the criticisms. Just last fall, Krugman, who is the most influential and representative Keynesian economist, did not even consider capital structure until someone sent him Murphy’s sushi article on capital structure for idiots, and he although he conceded it is possible, he claimed it cannot explain what we are going through, because our problem is aggregate demand aggregate demand aggregate demand.

Most Keynesians have never even heard of Austrian capital theory. That’s why they are not jumping left right and center.

If your appeal to other’s ignorance is the foundation for your seeming claim that Keynesians integrate time and hetereogeneity and they have no reason to worry about criticisms to the contrary because they are unfounded, is a very interesting, twisted version of the facts. Any Keynesian will tell you that the economy is most fundamentally about aggregate demand, spending, regardless of what spending it for. They hold spending to be primary, and the foundation for savings, investment, economic progress, employment, etc. If aggregate demand falls, then look out!

Have you ever considered that the reason for that is that they don’t disagree with you on it?

They would have to understand it first before they can know to not disagree with it, and most Keynesians do not understand it.

And no matter how many times I tell you that I never implied this for whatever reason you’re choosing to infer this, you’re still pushing this. Why?

Because I can read what you said. I already said if you don’t believe it, then that’s fine, but your words clearly imply it.

I’ve said, from the start:

Keynes talked a lot about heterogeneous capital in the initiation of his discussions of capital.

No, he did not. Keynes rarely spoke of it, and when he did, it was in passing only.

As he formulated his “first approximations” he introduced simplifying assumptions, including homogenizing capital

His “first approximations” are not to simplify for heterogeneous capital. The only time he even mentions first approximations is in the employment-consumption equilibrium, the approximating liquidity preference for hoarding, the separation of speculative cash holdings and transactions holdings, the investment multiplier being equal to the employment multiplier, the notion that profits vary in direct proportion to wages, and, most importantly, the notion that changes in employment depend solely on aggregate demand.

There is no first approximation that he uses to accommodate for any clear understanding that time structure and heterogeneity are important concepts in how the economy works, it’s just that there are more important concepts to consider.

There is only a passing mention of time and heterogeneity, and in no place are any of his first approximations meant to accommodate a simplifying of time and heterogeneity.

Adding capital heterogeneity doesn’t change the Keynesian mechanism and the behavior of capital from the first approximation model.

Yes, it in fact does, because Keynes’ theory depends on the assumption that only consumers can reward investments in general, that only consumers provide businesses with revenues that cover costs. If he integrated capital structure, he could have understood that capital goods companies also earn revenues, financed by savings, not consumption revenues.

Understanding that fact would have saved the world from the destruction unleashed by consumer spending oriented Keynesianism.

Forget what you think I’m implying – this is all I’ve ever said.

No, you said more, which I referred to already.

I’ve never suggested anything else.

Yes, you actually have. The fact that you are saying to me “I have said this over and over and over again” gives me the impression that you have been accused many times in the past of the same thing I am accusing you of. Maybe there is a reason for that you are not seeing.

I don’t know why you are so hell-bent on not taking my own word for what I am saying so that you can formulate my argument that makes us disagree more than we already do.

Sorry, I won’t take you on your word if it contradicts what you said in writing.

If I’m planning on buying the entire product of someone else’s acre of bluueberries for my pie factory but the government shows up first and buys 4/5 of the blueberries with new funny money, I think I’ve been crowded out.

The same thing cannot be in two places at the same time. A priori and all that.

I know I’m late to the party and I apologize if this has already been addressed but I want to bring up a couple issues I have with your first post:

” Keynesians focus on what the price mechanism cannot solve (macro-underutilization), rather than on the issues that all Keynesians I know of admit the price mechanism can solve (micro-coordination and relative utilization of resources).”

The price mechanism is not incapable of solving macro-underutilizitation; macro-underutilization is brought about and maintained by government policies that inhibit the price mechanism from working.

You quote Keynes:

” When 9,000,000 men are employed out of 10,000,000 willing and able to work, there is no evidence that the labour of these 9,000,000 men is misdirected.”

That depends. In a free market system, then yes, there is no a priori reason to believe the labor is being misdirected. However, if the government is interfering with the price mechanism, say by tampering with the interest rate, then there absolutely is reason to believe that labor is being misdirected.

” The complaint against the present system is not that these 9,000,000 men ought to be employed on different tasks, but that tasks should be available for the remaining 1,000,000 men.”

Perhaps there should be, but the more important question to me is WHY aren’t there more tasks available? I think Keynesian theory tends to ignore this question (or at least draw the wrong answer), and as a result frequently addresses the symptoms without addressing the underlying problem. We know that people have unlimited wants and limited means. So in a free market system, there is no reason for any involuntarily unemployment except frictional unemployment, primarily due to search costs/ lack of information.

Given government intervention, however, it is not necessarily wealth-enhancing to have full employment. For instance, if the 10% unemployment rate is due to a minimum wage law that makes the cost of hiring that last 10% of the labor force prohibitively high, the solution is *not* for the government to raise taxes so they can pay the unemployed workers to dig holes in the sand or worse, become bureaucrats. For these workers, MC>MR (to their prospective employers) — that’s why they weren’t hired in the first place — so society on net becomes poorer for this government solution. Not only that, but the tax increase makes firms less profitable, and as a result they might have to fire workers. They will also raise prices, which will reduce the total volume of trade and lead to layoffs in other sectors. This is an example of what I mean by addressing the symptoms without addressing the underlying problem, and as a result the underlying problem itself may get even worse or create new problems.

One more example, which highlights one of the problems of assuming homogeneous capital (and output). Now I know you said advanced Keynesian models build in heterogeneity, but fundamental Keynesian building blocks like the IS-LM model assume homogeneity of output, and implicitly of capital. The IS-LM model would have us believe that expansionary monetary policy will increase real output. While that may be true in the short run (due to capital consumption as Murphy describes it), the lowering of the interest rate also sets in motion misallocations of resources that cause the business cycle which inevitably collapses, leaving society worse off than before the monetary pumping. The model itself is not equipped to handle this type of analysis, which is why the Austrian perspective is so important.

” It is in determining the volume, not the direction, of actual employment that the existing system has broken down.”

Volume and direction are not independent of each other. To increase the volume of employment (and wealth), it is vital that resources are employed in their most productive ways. And again, it is not the fault of the price system when this doesn’t occur, but of government attempts to subvert the price system.

re: “We know that people have unlimited wants and limited means. So in a free market system, there is no reason for any involuntarily unemployment except frictional unemployment, primarily due to search costs/ lack of information.”

Why are you under the impression that your second sentence follows from your first? I’m unclear on the logic.

I’m not even so sure about the first, but it’s good enough.

As for the rest of what you write – you’re sort of assuming your own conclusions. If the frictional unemployment/price floor argument you lay out is the source of unemployment, then yes of course Keynesianism is only treating symptoms. You don’t do much by explaining the logic of a price floor to us. We get why it would be counterproductive under those conditions. The question is – are those the circumstances in which we actually find ourselves!

re: “the lowering of the interest rate also sets in motion misallocations of resources that cause the business cycle which inevitably collapses, leaving society worse off than before the monetary pumping.”

This is assuming the interest rate was right to begin with. The IS-LM model suggests that we get downturns when the interest rate is artificially high. Austrians and Keynesians are really talking past each other in this sense. The Austrians sound crazy to the Keynesians because the Austrians sound like they are advocating interest rates higher than market equilibrium. The Keynesians sound crazy to the Austrians because the Keynesians sound like they are advocating interest rates lower than market equilibrium. If you put ABCT onto an IS-LM model, you would have an artificially shortened capital structure that is corrected by monetary policy. You’re implicitly assuming stimulus pushes interest rates too low. You’re assumign your own conflict with Keynesianism.

“Why are you under the impression that your second sentence follows from your first? I’m unclear on the logic.

I’m not even so sure about the first, but it’s good enough.”

The first is just another way of stating the local non-satiation of preferences standard in microeconomic theory. Although I prefer to look at it the Misesian way, i.e the reason we act is to remove felt uneasiness; our ceaseless action is evidence of our unfulfilled wants. I guess you could argue that we have limited wants but they’re so vast we can never achieve them all, but whatever.

If we have unlimited wants and limited means, given that people have comparative advantages, there are always potential gains from trade. Even the most unskilled worker has a comparative advantage over someone in something. Aside from frictions, why do you or Keynes posit that these trades wouldn’t take place?

From my (limited) knowledge of Keynes, he would say that, at least during a recession, aggregate demand has fallen. But why has AD fallen? If the Austrians are correct, then there has been a massive misallocation of resources; when the bust rears its head, people realize that they have much less wealth than they thought they did, and so they cut back on spending in light of this reality. This will cause AD to fall. But if this reasoning is correct, then the solution is not to pump money into the system to keep this wealth-destroying capital structure afloat; that will only make things worse. The correct response is to let market prices adjust so that the resources can be reallocated to their most valuable uses.

What is the Keynesian explanation, or yours, for business cycles? Animal spirits?

“The IS-LM model suggests that we get downturns when the interest rate is artificially high. ”

My point with the IS-LM model is that, at least the way I learned it, it shows that lowering the interest rate — regardless of where the equilibrium rate is — will increase real output. This myopic conclusion can only be drawn because the model ignores heterogeneity in capital and output.

That aside, why would the interest rate be artificially high? We know that in a free market, market forces don’t cause prices to be exactly in equilibrium, but they do push prices toward equilibrium.

I assume you’re familiar with Mises’ social calculation argument; how, then, could a central bank possibly have better knowledge than the market about what the true equilibrium rate of interest is? Just like one can’t know how much food or clothes or ipods should cost without a market, the government is equally clueless about what the interest rate should be; by suppressing market forces, the central bank denies themselves the information that causes prices to tend toward equilibrium.

As I mentioned, the central bank has no way of knowing what the equilibrium rate of interest is. It strikes me as supremely arrogant for the central bank to presume that they know better than the markets what the interest rate ought to be, just as it is arrogant for all social planners to think they can price and distribute resources more effectively than free actors. While I can’t say with absolute certainty that stimulus pushes the interest rate too low, it sure seems 99.99% likely that it is indeed the case (see: housing bubble). We can’t run controlled experiments in economics, but the Austrian story makes a lot more sense to me than the Keynesian one, both in theory and with regard to the data.

Lastly: why do you believe the price mechanism cannot solve macro-underutilization? I claim that the price mechanism is capable of solving this problem, but is prevented from doing so by government. Why do you disagree?

re: “That aside, why would the interest rate be artificially high? We know that in a free market, market forces don’t cause prices to be exactly in equilibrium, but they do push prices toward equilibrium.”

We know that relative prices are pushed to equilibrium. We also know that in a free market, market forces are often powerless against a macro disequilibrium. Again, you seem to be assuming your own conclusions here. If market forces always solve problems of disequilibrium then of course there’s no point to Keynesianism. This is the very bone of contention. Citing this assumption doesn’t demonstrate anything – clearly I know what follows from this assumption – the question is, is it reasonable to make.

re: “I assume you’re familiar with Mises’ social calculation argument; how, then, could a central bank possibly have better knowledge than the market about what the true equilibrium rate of interest is?”

The government is relatively clueless. It’s probably best to say that the market achieves and equiliibrium interest rate, it simply is often the wrong equilibrium. Multiple equilibrium interest rates are possible, and the market often settles on an interest rate corresponding to an underutilization of resoruces. This answers your last question to about macro-underutilization. I’m sorry, I don’t have time to go into the details now, but you can think of Keynesianism as a model that presents multiple equilibria for the interest rate, and the economy can be trapped in a sub-optimal equilibrium.

“While I can’t say with absolute certainty that stimulus pushes the interest rate too low, it sure seems 99.99% likely that it is indeed the case (see: housing bubble).”

Isn’t that the whole point? Governments There is a conflict of interest; it is in the government’s interest to hold rates too low and push ‘stimulus’, artificially engineering false “booms” and false “recoveries” by stimulating consumption spending out of savings (like what is happening right now), because creating the illusion of false prosperity or false recovery is what wins votes come re-election time. Arguably it may be that Bush got re-elected because this precise type of policy managed to convince everyone they were living in the biggest boom ever, making everyone feel as if they were so prosperous we could all afford big houses, and thereby misdirecting large amounts of society’s production resources towards home building and furnishing, and away from factories etc. where actual wealth is produced.

This is why Krugman argued in 2002 for creating a housing bubble.

In hindsight the public now knows it was a huge bubble but the old administration just passed the hot potato to the new administration. Now the new administration has been artificially engineering a new “false recovery” for mid-terms and for the upcoming presidential election, by pushing such massive “stimulus”, and they don’t care about the consequences because the mess lies just far enough in the future that the next administration will be left with it.

My point is that governments have an inherent conflict of interest in how they abuse the interest rate mechanism to try “steer” economies, and it will tend to be in the direction that gives a false positive impression of the state of the economy, and they don’t care if actual manufacturing etc. is harmed. That’s why it’s bubble after bubble.

How did I miss that one? I spend a fair share of time thinking about and reading about Keynesianism and I’m also fairly on top of policy discussions. An odd thing for me to miss. You could have fooled me!

For the record I think it’s cool of you to post on a blog where the majority of people disagree with you. Anyways, I gotta jump in on this other argument you’re having with Bob Roddis.

If I understand you correctly, your point is the following (I’m changing the units for ease of example): If consumers are only willing to buy 1/5 of the cars available, then the government can come in and buy 4/5 of the cars and this won’t crowd out private spending because AS was greater than AD to begin with.

However, this is not the whole story. When the car manufacturer receives the new money from the government, he will use it to invest in more steel and factory equipment and other resources for his own production which will reduce the supply and raise the price of these capital goods, thereby preventing them from flowing into other sectors of the economy. So private investment in the productive sectors still gets crowded out by government spending in the inefficient sectors. This is why government spending can only serve to prop up wealth-destroying capital structures.

This is why having the government buy or encourage people to buy a single product as stimulus can be distortionary. If there’s a legitimate public good/public investment worth making on its own merits, by all means just spend on that. But otherwise, this is why people prefer monetary policy to the government going out and buying 4/5ths of the cars.

What you are talking about is a relative distortion or crowding out in specific markets rather than a general crowding out. Bob was refering to a more general crowding out, but he was assuming the conditions that would make it crowding out! Why would AP Lerner argue with him under those circumstances!

“This is why having the government buy or encourage people to buy a single product as stimulus can be distortionary. If there’s a legitimate public good/public investment worth making on its own merits, by all means just spend on that.”

This is why I think Keynesians misdiagnose the underlying problem. I’m not sure what qualifies a “legitimate public good investment worth making on its own merit”, but regardless of whether we’re talking about a single market or all markets, the reason AS>AD is because for the surplus goods, their MC>MB to prospective buyers; having the government come in and purchase them at the given price therefore creates deadweight loss — these purchases make society poorer. Plus the distortionary effects already mentioned, as well as the additional deadweight loss caused by raising taxes or the pernicious effects of inflation if the gov pays for it by printing money.

“What you are talking about is a relative distortion or crowding out in specific markets rather than a general crowding out.”

Fair enough, but wouldn’t you agree that this problem is just as serious? This is why the Austrians defend ABCT as a malinvestment story rather than one of overinvestment. Would you disagree that this type of malinvestment can fuel the boom-bust cycle, especially when government continues to inflate the money supply, thereby preventing market agents from even realizing that resources are being funneled into unproductive channels?

“Multiple equilibrium interest rates are possible,”

We’re working with different definitions of equilibrium here. When I say equilibrium rate, I mean the rate that clears the market for loanable funds. At any given time there is only one true equilibrium rate (for a particular interest rate of course, i.e the Fed Funds rate); just like S&D graphs give way to a single equilibrium (market-clearing) price.

” It’s probably best to say that the market achieves and equiliibrium interest rate, it simply is often the wrong equilibrium…

and the market often settles on an interest rate corresponding to an underutilization of resoruces…

We also know that in a free market, market forces are often powerless against a macro disequilibrium… “

If this is what you believe, then the burden of proof is on YOU to show why we should disregard basic S&D analysis. Basic S&D analysis shows that market forces push prices toward market-clearing equilibrium; this is one of the foundations of economic theory. Why does this suddenly become invalidated when we move from the micro to the macro realm?

re: “I’m not sure what qualifies a “legitimate public good investment worth making on its own merit”, but regardless of whether we’re talking about a single market or all markets, the reason AS>AD is because for the surplus goods, their MC>MB to prospective buyers; having the government come in and purchase them at the given price therefore creates deadweight loss — these purchases make society poorer.”

You are still assuming that the supply side of the MC facing investors is savers in the loanable funds market. If this is true, then I’m more than happy to agree with you. I simply don’t think this is true. We’ve gotta wean ourselves off this loanable funds determination of the interest rate stuff.

re: “Fair enough, but wouldn’t you agree that this problem is just as serious?”

Sometimes its more serious even. Sometimes its much less serious. Relative distortions strike me as being so distant a problem at this point, that it seems silly to worry too much about them until we get closer to full employment.

re: “We’re working with different definitions of equilibrium here. When I say equilibrium rate, I mean the rate that clears the market for loanable funds.”

Right – this is where we break off. If I were to think of the equilibrium interest rate in those terms, then I would be agreeing with you.

re: “If this is what you believe, then the burden of proof is on YOU to show why we should disregard basic S&D analysis”

Now hold on – I don’t disregard basic S&D analysis any more than you do. Don’t confuse rejection of exclusive reliance on the supply and demand for loanable funds as rejection of supply and demand. There are other things to be supplied and demanded (namely, liquidity). The question then is – what theory best models reality and makes the most sense logically: a theory entirely reliant on a loanable funds theory of the interest rate or a theory incorporating loanable funds and liquidity preference?

“You are still assuming that the supply side of the MC facing investors is savers in the loanable funds market. If this is true, then I’m more than happy to agree with you. I simply don’t think this is true. We’ve gotta wean ourselves off this loanable funds determination of the interest rate stuff.”

We do? So you are arguing that the interest rate — the price banks charge to loan funds — is not determined by the supply and demand of loanable funds?

Aside from that, my point was more general; I wasn’t just talking about the interest rate, I’m talking about any market. Take cars, or whatever. If there are many more cars on the lot than consumers are willing to buy, that means that the cars’ MC>MB to the prospective buyers. Do we agree on that much? If so, then we also agree that if the government steps in to buy the cars at their current price, that will make make society poorer by misallocating resources. Do we agree? If so, please explain why these principles do not apply when we consider the market for loanable funds (or whatever other market you think determines the interest rate?).

“There are other things to be supplied and demanded (namely, liquidity). The question then is – what theory best models reality and makes the most sense logically: a theory entirely reliant on a loanable funds theory of the interest rate or a theory incorporating loanable funds and liquidity preference?”

Liquidity preference is simply one factor that influences people’s subjective valuation of loaning or borrowing funds. It’s two sides of the same coin. This would be like asking: “What theory best models the market for clothing and makes the most sense logically: a pricing theory entirely reliant on supply and demand or a theory incorporating S&D and fashion preference?”

If all of a sudden people’s demand for liquidity increases, that will increase the demand for and shrink the supply of loanable funds. This of course will push the interest rate up; but it is important to realize the interest rate is not “artificially” high in this case; real changes have occurred in people’s subjective valuations of money, and the equilibrium (and actual) interest rate shift in light of this new reality. Resources are not being underutilized; rather, some resources are purposefully not being utilized because it is too costly to utilize them at the present time given their price — their MC>MB. So when the government injects stimulus, they may be pushing the interest rate back toward the old rate, but that is not where the actual equilibrium rate is. The actual equilibrium rate is much closer to where market forces are pushing it.

Relative distortions strike me as being so distant a problem at this point, that it seems silly to worry too much about them until we get closer to full employment.

I think it is a serious error to view these as separate issues. Relative distortions *cause* underemployment. Relative distortions due to government intervention cause resources to flow into inefficient production lines. Once people realize what has happened, the bust phase hits and people get laid off while the market figures out how to reallocate resources into their most valuable lines of production. When the government further intervenes with stimulus packages, all they do is prop up the faulty capital structure that prevents resources (including workers) from being reallocated to productive uses. That is why we’re still stuck at such a high unemployment rate.

What do you think prevents supply and demand forces in the labor market from eliminating involuntary unemployment if not the government?

Without getting into the serious economics debate here, let me make a couple of observations about the depressing graph you displayed on the full post at Von Mises.

First, there are some astonishingly optimistic assumptions worked into the already depressing scenario. it represents a “best-case scenario.” The president’s budget proposal, and the graph that came from it, was really a weak exercise, and The Economist called it a “cop out.”

Second, I am generally more concerned with the accumulation of publicly held debt than the deficit per se. The publicly held debt will rise faster due to mid-year appropriations. That explains why the new OMB numbers show a $187 billion larger rise in PHD than the deficit for 2011. Again, the chart is a best case scenario.